The years that preceded the turbulence saw an exceptionally strong performance of the world economy – another phase of what has come to be known as the “Great Moderation”.

Following the global slowdown of 2001, the world economy had recovered rather rapidly, posting record growth rates in 2004, 2005 and 2006. The long period of abundant liquidity and low interest rates prior to the crisis led to a global search for yield and a general under-pricing of risk by investors. Across a wide spectrum of asset classes, volatilities and risk premia looked exceptionally low compared with fixed income credit, equity and foreign exchange markets.

There were ‘global imbalances’, the phenomenon of huge current account surpluses in China and few other countries coexisting with the unsustainably large deficits in the US. This imbalance was caused by the propensity of the countries with high saving rate to park their savings often at low yields, in the US. The flood of money from these countries into the US kept interest rates low, fueled the credit boom and inflated real estate and other asset prices to unsustainable levels.

– Rapid increase in credit

Against the backdrop of the historically low interest rates and booming asset prices, credit aggregates, along side monetary aggregates, had been expanding rapidly. Despite the rapid increase in credit, however, the balance-sheets and repayment capacity of corporations as also the households did not appear to be under any strain. The high level of asset prices kept the leverage ratios in check while the combination of strong income flows and low interest rates did the same with debt service ratios.

-- Failure of the US Leadership in anticipating the crisis

During the housing boom, most of the US authorities failed to comprehend the problem. Alan Greenspan, the then head of Federal Reserve, in his book 'The Age of Turbulence', recalled what he used to say about the housing boom: "I would tell audiences that we were facing not a bubble but a froth – lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy."

* Key Triggers

- Sub-prime mortgage

The meltdown originated in the sub-prime mortgage crisis in USA in 2007. With easy availability of credit at low interest rates, real estate prices in US had been rising rapidly since the late 1990s and investment in housing had assured financial return. US home-ownership rates rose over the period 1997-2005 for all regions, all age groups, all racial groups, and all income groups.

The boom in housing sector made both banks and home buyers believe that the price of a real estate would keep going up. Housing finance seemed a very safe bet. Banks went out of their way to lend to sub-prime borrowers who had no collateral assets. Low income individuals who took out risky sub-prime mortgages were often unaware of the known risks inherent in such mortgages. While on the one hand, they were ever keen to become house-owners, on the other, they were offered easy loans without having any regard to the fact that they were not in a position to refinance their mortgages in the event of the crisis. All this was fine as long as housing prices were rising. But the housing bubble burst in 2007. Home prices fell between 20 per cent and 35 per cent from their peak and in some areas more than 40 per cent; mortgage rates also rose. Sub-prime borrowers started defaulting in large numbers. The banks had to report huge losses.

- Excessive Leverage

The final trigger came from excessive leverage. Investors bought mortgage-backed securities by borrowing. Some Wall Street Banks had borrowed 40 times more than they were worth. In 1975, the Securities Exchange Commission (SEC) established a net capital rule that required the investment banks who traded securities for customers as well as their own account, to limit their leverage to 12 times. However, in 2004 the Securities and Exchange Commission (SEC) allowed the five largest investment banks – Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley – to more than double the leverage they were allowed to keep on their balance sheets, i.e. to lower their capital adequacy requirements.

* The Meltdown

Initially started as a liquidity problem, it soon precipitated into a solvency problem, making US financial institutions search for capital that was not readily available. Bear Stearns was sold to the commercial bank J.P. Morgan Chase in mid-March 2008; Lehman Bros filed for bankruptcy in mid-September 2008; Merrill Lynch was sold to another commercial bank, Bank of America and finally Morgan Stanley and Goldman Sachs signed a letter of intent with US Federal Reserve on September 22, 2008 to convert themselves.

* Impact of the Economic Crisis on India

With the increasing integration of the Indian economy and its financial markets with rest of the world, there were downside risks from these international developments. These included:

- Capital Outflow

The main impact of the global financial turmoil in India has emanated from the significant change experienced in the capital account in 2008-09, relative to the previous year. Total net capital flows fell from US$17.3 billion in April-June 2007 to US$13.2 billion in April-June 2008.

-Impact on Stock and Forex Market

With the volatility in portfolio flows having been large during 2007 and 2008, the impact of global financial turmoil was been felt particularly in the equity market. Indian stock prices were severely affected by foreign institutional investors' (FIIs') withdrawals. FIIs had invested over Rs 10,00,000 crore between January 2006 and January 2008, driving the Sensex 20,000 over the period. But from January, 2008 to January, 2009 this year, FIIs pulled out from the equity market partly as a flight to safety and partly to meet their redemption obligations at home. These withdrawals drove the Sensex down from over 20,000 to less than 9,000 in a year.

- Impact on the Indian Banking System

One of the key features of the current financial turmoil had been the lack of perceived contagion being felt by banking systems in emerging economies, particularly in Asia. The Indian banking system also had not experienced any contagion, similar to its peers in the rest of Asia. The Indian banking system was not directly exposed to the sub-prime mortgage assets. It had very limited indirect exposure to the US mortgage market, or to the failed institutions or stressed assets.

A detailed study undertaken by the RBI in September 2007 on the impact of the sub-prime episode on the Indian banks had revealed that none of the Indian banks or the foreign banks, with whom the discussions had been held, had any direct exposure to the sub-prime markets in the USA or other markets.

However, a few Indian banks had invested in the collateralised debt obligations.

(CDOs)/ bonds which had a few underlying entities with sub-prime exposures.